DERIVATIVES AND RISK MANAGEMENT ACTIVITIES

We utilize various derivative instruments to: (i) manage our exposure to commodity price risk; (ii) manage our exposure to interest rate risk; and (iii) attempt to profit from market fluctuations. Our risk management policies and procedures are designed to monitor interest rates, futures and swap positions and over-the-counter positions, as well as physical volumes, grades, locations and delivery schedules, to help ensure that our hedging activities address our market risks. Our risk management committee oversees our trading controls and procedures and certain aspects of our commodity and trading risk management. Our risk management committee also reviews all new commodity and trading risk management strategies in accordance with our risk management policy, which was approved by our board of directors.

Interest Rate Risk

We are a party to certain interest rate swap agreements to manage our exposure to changes in interest rates. We entered into fixed-to-floating interest rate swap agreements associated with a portion of our fixed-rate senior notes. During the six months ended June 30, 2012, we entered into and terminated fixed-to-floating interest rate swap agreements with an aggregate notional amount of $200.0 million related to the 4.75% senior notes issued on February 2, 2012. Under the terms of these interest rate swap agreements, we received a fixed 4.75% and paid a variable rate based on one month USD LIBOR plus a percentage that varied with each agreement. We also terminated fixed-to-floating interest rate swap agreements with an aggregate notional amount of $270.0 million associated with our 4.80% senior notes. We received $19.7 million in connection with the terminations, which we are amortizing into “Interest expense, net” over the remaining lives of the 4.80% and 4.75% senior notes. We had no fixed-to-floating interest rate swaps as of June 30, 2012, and the total aggregate notional amount of the fixed-to-floating interest rate swaps was $270.0 million as of December 31, 2011.

We are also a party to forward-starting interest rate swap agreements related to forecasted probable debt issuances. We entered into these swaps in order to hedge the risk of changes in the interest payments attributable to changes in the benchmark interest rate during the period from the effective date of the swap to the issuance of the forecasted debt. These swaps are designated and qualify as cash flow hedges. In connection with the issuance of the 4.75% senior notes on February 2, 2012, we terminated forward-starting interest rate swap agreements with an aggregate notional amount of $225.0 million. We paid $25.4 million in connection with the terminations, which is being amortized into “Interest expense, net” over the life of the 4.75% senior notes. The termination payment is included in cash flows from financing activities on the consolidated statements of cash flows. As of June 30, 2012 and December 31, 2011, the total aggregate notional amount of the forward-starting interest rate swaps was $275.0 million and $500.0 million, respectively.

Commodity Price Risk

We are exposed to market risks related to the volatility of crude oil and refined product prices. In order to reduce the risk of commodity price fluctuations with respect to our crude oil and finished product inventories and related firm commitments to purchase and/or sell such inventories, we utilize commodity futures and swap contracts, which qualify and we designated them as fair value hedges.

We also enter into commodity swap contracts to hedge the price risk associated with the San Antonio refinery. These contracts fix the purchase price of crude oil and sales prices of refined products for a portion of the expected production of the San Antonio refinery, thereby attempting to mitigate the risk of volatility of future cash flows associated with hedged volumes. These contracts qualify and we designated them as cash flow hedges. During the second quarter of 2012, we reduced the hedged volumes of the expected production of the San Antonio refinery, thereby exposing us to additional price risk.

Derivatives that are intended to hedge our commodity price risk, but fail to qualify as fair value or cash flow hedges, are considered economic hedges, and we record associated gains and losses from such derivatives in net income. We also enter into commodity derivatives in order to attempt to profit from market fluctuations. These derivative instruments are financial positions entered into without underlying physical inventory and are not considered hedges. Changes in the fair values are recorded in net income.

The volume of commodity contracts is based on open derivative positions and represents the combined volume of our long and short positions on an absolute basis, which totaled 32.0 million barrels and 27.8 million barrels as of June 30, 2012 and December 31, 2011, respectively.

The fair values of our derivative instruments included in our consolidated balance sheets were as follows:



		Asset Derivatives				Liability Derivatives
	Balance Sheet Location	June 30, 2012		December 31, 2011		June 30, 2012			December 31, 2011
		(Thousands of Dollars)
Derivatives Designated as Hedging Instruments:
Commodity contracts	Other current assets	$	5,776	$	36,116	$	(5,010	)	$	(33,616	)
Commodity contracts	Other long-term assets, net	36,782		86,052		(27,220		)	(66,175		)
Interest rate swaps	Other long-term assets, net	—		2,335		—			—
Commodity contracts	Accrued liabilities	35,863		—		(50,514		)	—
Interest rate swaps	Accrued liabilities	—		—		(37,291		)	(22,009		)
Commodity contracts	Other long-term liabilities	9,652		—		(16,496		)	—
Interest rate swaps	Other long-term liabilities	—		—		—			(27,190		)
Total		88,073		124,503		(136,531		)	(148,990		)

Derivatives Not Designated as Hedging Instruments:
Commodity contracts	Other current assets	91,480		15,568		(46,371		)	(5,956		)
Commodity contracts	Other long-term assets, net	13,921		7,207		(14,387		)	—
Commodity contracts	Accrued liabilities	32,997		519		(55,483		)	(5,943		)
Commodity contracts	Other long-term liabilities	20,279		—		(14,780		)	—
Total		158,677		23,294		(131,021		)	(11,899		)

Total Derivatives		$	246,750	$	147,797	$	(267,552	)	$	(160,889	)

The earnings impact of our derivative activity was as follows:



Derivatives Designated as Fair Value Hedging Instruments	Income Statement Location	Amount of Gain (Loss) Recognized in Income on Derivative (Effective Portion)			Amount of Gain (Loss) Recognized in Income on Hedged Item			Amount of Gain (Loss) Recognized in Income on Derivative (Ineffective Portion)
		(Thousands of Dollars)
Three months ended June 30, 2012:
Interest rate swaps	Interest expense, net	$	(19,573	)	$	19,573		$	—
Commodity contracts	Cost of product sales	5,222			(5,837		)	(615		)
Total		$	(14,351	)	$	13,736		$	(615	)

Three months ended June 30, 2011
Interest rate swaps	Interest expense, net	$	14,528		$	(14,812	)	$	(284	)
Commodity contracts	Cost of product sales	1,002			(1,650		)	(648		)
Total		$	15,530		$	(16,462	)	$	(932	)

Six months ended June 30, 2012:
Interest rate swaps	Interest expense, net	$	(17,345	)	$	17,345		$	—
Commodity contracts	Cost of product sales	2,635			(3,447		)	(812		)
Total		$	(14,710	)	$	13,898		$	(812	)

Six months ended June 30, 2011:
Interest rate swaps	Interest expense, net	$	8,614		$	(8,852	)	$	(238	)
Commodity contracts	Cost of product sales	(11,064		)	10,720			(344		)
Total		$	(2,450	)	$	1,868		$	(582	)



Derivatives Designated as Cash Flow Hedging Instruments	Amount of Gain (Loss) Recognized in OCI on Derivative (Effective Portion)			Income Statement Location (a)	Amount of Gain (Loss) Reclassified from Accumulated OCI into Income (Effective Portion)			Amount of Gain (Loss) Recognized in Income on Derivative (Ineffective Portion)
	(Thousands of Dollars)				(Thousands of Dollars)
Three months ended June 30, 2012:
Interest rate swaps	$	(16,749	)	Interest expense, net	$	(629	)	$	—
Commodity contracts	4,461			Cost of product sales	(8,518		)	—
Total	$	(12,288	)		$	(9,147	)	$	—

Three months ended June 30, 2011
Interest rate swaps	$	(15,708	)	Interest expense, net	$	—		$	—
Commodity contracts	(16,454		)	Cost of product sales	(1,225		)	—
Total	$	(32,162	)		$	(1,225	)	$	—

Six months ended June 30, 2012:
Interest rate swaps	$	(13,451	)	Interest expense, net	$	(1,052	)	$	—
Commodity contracts	(52,660		)	Cost of product sales	(15,862		)	4,010
Total	$	(66,111	)		$	(16,914	)	$	4,010

Six months ended June 30, 2011:
Interest rate swaps	$	(12,830	)	Interest expense, net	$	—		$	—
Commodity contracts	(16,454		)	Cost of product sales	(1,225		)	—
Total	$	(29,284	)		$	(1,225	)	$	—


(a)	Amounts are included in specified location for both the gain (loss) reclassified from accumulated other comprehensive income (OCI) into income (effective portion) and the gain (loss) recognized in income on derivative (ineffective portion).



Derivatives Not Designated as Hedging Instruments	Income Statement Location	Amount of Gain (Loss) Recognized in Income
		(Thousands of Dollars)
Three months ended June 30, 2012:
Commodity contracts	Revenues	$	(8,164	)
Commodity contracts	Cost of product sales	28,255
		$	20,091

Three months ended June 30, 2011
Commodity contracts	Revenues	$	(29	)
Commodity contracts	Cost of product sales	4,462
		$	4,433

Six months ended June 30, 2012:
Commodity contracts	Revenues	$	(7,654	)
Commodity contracts	Cost of product sales	23,937
		$	16,283

Six months ended June 30, 2011:
Commodity contracts	Revenues	$	235
Commodity contracts	Cost of product sales	(11,167		)
Commodity contracts	Operating expenses	46
		$	(10,886	)

For derivatives designated as cash flow hedging instruments, once a hedged transaction occurs, we reclassify the effective portion from accumulated OCI to “Cost of product sales” or “Interest expense, net.” As of June 30, 2012, we expect to reclassify a loss of $9.1 million to “Cost of product sales” and a loss of $2.5 million to “Interest expense, net” within the next twelve months. The maximum length of time over which we are hedging our exposure to the variability in future cash flows is approximately three years for our commodity contracts and one year for our forward-starting interest rate swaps.